Sunday, November 2, 2008
Reader William asked about recent Fed and Treasury actions; specifically, which act is more likely to cause inflation going forward: “would you strictly adhere to thinking the net money creation above treasury issuances is the inflationary tinder? Or is the issuance of government debt inflationary when it is offset by central bank accommodation?”
It is the Fed’s creation of money – through its slew of new credit programs – that will eventually cause an inflationary boom if not taken back (the highlighted portion of your question). The Treasury is sterilizing the Fed’s liquidity measures, rather than the Fed monetizing the Treasury’s debt (just add this to a long list of unprecedented acts by the Fed and the Treasury).
A little economic jargon for some: sterilizing the monetary base and monetizing government debt
First, let’s address sterilizing the monetary base. The Fed’s standard monetary transaction is to maintain the federal funds rate - the interest rate at which U.S. banks make overnight loans to each other - at (or close to, see this post ) the Fed’s chosen target by injecting (the rate falls) and extracting (the rate rises) liquidity from the banking system. Usually the Fed does this through repurchase agreements (repos) or by manipulating the stock of Treasuries on its balance sheet (see Table below).
However, when the Fed wants to keep the federal funds rate unchanged but add liquidity by other means (perhaps by auctioning off funds), the Fed sterilizes the effects of the new liquidity on the monetary base by performing an offsetting open market operation - an overnight repo or selling Treasuries outright.
The counterfactual: The Fed does not sterilize a new TAF auction – let’s say in the amount of $150 billion – and the money supply rises. The Fed allows the new $150 billion to stay in the banking system as excess reserves, which increases the supply of federal funds and reduces the federal funds rate (below the Fed’s target). The money supply increases as banks loan out the new funds, which is inflationary – too much money chasing the same number of goods and services.
Second, Mark Thoma presents a nice example of monetizing government debt - the Fed sterilizes the negative impact on the money supply of the Treasury selling new debt to finance expenditures that exceed its revenue base:
- Suppose the government runs a deficit. As an example, let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.
- The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.
- Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).
- The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.
- Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.”
So Who’s Monetizing/Sterilizing Who?
The Fed is not monetizing Treasury debt, but the Treasury is sterilizing Fed flows. This new phenomenon is easy to see on the Fed’s balance sheet over the last 2 months.
(Click on Table to enlarge)
The Fed has loosened its reins on liquidity flows and is pumping the banking system with enough liquidity to fill the Amazon River. The ABCP facility has grow by $120 billion since August when it did not exist, PDCF has growth by $87 billion since August when it was $0, the TAF program has doubled in size to $301 billion with another $750 billion scheduled through March 2009, and the Fed now holds roughly $500 billion in currency swaps that it didn’t hold last year (most of the Other Assets). But this liquidity must be sterilized, and the Fed performs offsetting open market operations, generally selling Treasuries on the open market, for each new measure.
However, by sterilizing its own massive liquidity operations, the Fed’s stock of Treasuries has almost halved since last year, down to $490 billion at the end of October 2008 from $780 billion in October 2007. In steps the U.S. Treasury and the Treasury Supplemental Financing Program (TSFP) to save the day.
(Click on Table to enlarge)The Fed has transferred the job of sterilizing its liquidity injections exclusively to the Treasury since the TSFP account has grown five-fold in just one month (see liabilities Table above). Now when the Fed issues $150 billion in TAF credit, the Treasury sells bonds on the open market (rather than the Fed doing this) and deposits the proceeds into the Fed’s account, currently $559 billion in the U.S. Treasury Supplemental account (the TSFP). The Fed’s stock of treasuries remains unchanged.
So why isn’t this a monetization of Treasury debt? First because the TSFP balance has risen, which is a liability to the Treasury. But more importantly, the Fed has increased its liquidity measures by $1 trillion since August, and reserve balances have ballooned 30 times over, up from $9 billion in August to $261 billion in October. This is not an act of monetization of Treasury debt because banks are hoarding the funds as excess reserves – reserves held in addition to those required by the Fed.
(Click on chart to enlarge)The ballooning reserves are a result of the new monetary base in the banking system - the Fed’s response to the credit crisis - and not the monetization of new spending by the Treasury.
At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks. As soon as the cork that is stopping up the credit flow in the banking system pops, the Fed must remove the excess liquidity in order to avoid an inflationary boom.